Phillips Curve

lecture 14- economics 202

three inflationary forces- causes of inflation

1. inflation expectations

2. demand-pull inflation (Phillips curve)

3. supply shocks and cost-push inflation

inflation expectations

the rate at which average prices are anticipated to rise next year

demand-pull inflation

inflation resulting from excess demand

• when demand outstrips a business’ productive capacity= raise prices

scaling up

when demand exceeds the economy’s productive capacity- prices rise

cost push inflation

inflation the results from an unexpected rise in production costs

• when an unxpected boost to production costs pushes sellers to raise their prices

all pieces together

inflation = expected inflation + demand pull inflation +cost push inflation

set prices to take account of inflation expectations

two factors:

• your marginal cost

  • if supplier raises prices, then you have to charge higher prices to make up for marginal costs

• your competitor’s prices

  • competitors also facing rising input costs so they will be raising prices as well- can raise prices along side them and remain competitive

• should raise your prices for next year because you expect other businesses (both your suppliers and competitors) to raise their prices

self fulfilling prophecy

inflation expectations create inflation

• widespread expectation of any particular inflation rate is enoug to push suppliers to raise their prices so that theyll create that inflation

  • if people expect high inflation, they will get high inflation

  • if people expect low inflation, they will get low inflation

policy makers goal

convince people that future inflation is going to be low, even when businesses are experiencing a temporary rise in inflation

three ways to track inflation expectations

• surveys

  • survey a representative group of people about their inflation expectations

• economist’s forecasts

  • ongoing survey of professional economists regarding their inflation forecasts

• financial markets

  • the 10 year break - even rate suggests what investors expect inflation to be over the next 10 years

adaptive expectations

people who expect recent levels fo inflation to continue

anchored expectations

people who believe the Fed will deliver on its promist to ensure inflation stays around 2%

rational expectations

people who use all available data to come up with the most accurate forecast possible

sticky expectations

people who revisit their vews on inflation only irregularly, so they stick with their previous view

demand pull inflation pt 2

when excess demand pulls inflation up, so that it rises above expected inflation

• can also pull inflation below inflation expectations when demand in unexpectedly weak

• when demand mathces economy productive capacity, there’s no demand pull inflation

insufficient demand

when the quantity demanded at the prevailing price is below what’s supplied

2 observations

one) demand pull inflation is driven by output gap

• when there’s a positive output gap (actual > potential) , there’s excess demand

• when there’s a negative output gap (actual < potential), there’s insuffiecient demand

two) demand pull inflation leads inflation to diverge from inflation expectations

• it drives unexpected inflation

  • unexpected inflation= inflation- inflation expectations

phillips curve is upward sloping

• x-axis is output gap

• y-axis is unexpected inflation

  • zeroes are in the middle of both axises

higher output relative to potential leads to greater inflationary pressure

if unexpected inflation is…

zero= actual inflation equals expected inflation

negative= actual inflation will be less than expected inflation

• does not mean actual inflation is negative

positive= actual inflation will be greater than expected inflation

when output exceeds potential output

• excess demand leads managers to raise prices more

• inflation rises above expected inflation

• positive direction (above 0)

When output is equal to potential output

• absence of demand-pull inflation

• inflation equals unexpected inflation

when output is less than potential output

• insufficient demand leads to price restraint

• inflation falls below expected inflation

  • have to start dropping prices

using the philips curve to forecast inflation:

step 1) assess inflation expectations

• analyze surveys of inflation expectations, survey of economists, or financial-based measures

step 2) forecast unexpected inflation

• start with output gap estimate

• look up and across the phillips curve to get your forecast of unexpected inflation

supply shocks

any change in production costs that leads suppliers to change the prices they charge at any given level of output

three causes of supply shock that will shift the phillips curve

• input prices

• productivity

• exchange rates

input prices as a shifter of the phillips curve

if prices of inputs rise

• marginal costs rise- raise prices

• boosts inflation at any given level of the output gap

important input prices:

• oil and commodity prices

  • oil can act as a key source of cost-push inflation

• rising wages

wage price spiral

a cycle where higher prices lead to higher nominal wages, which leads to higher prices

productivity as a shifter of the curve

• faster than expected productivity growth lowers marginal costs

  • greater price restraint at any given output gap

  • form of negative cost-push inflation

  • phillips curve shifts down

exchange rates as a shifter

• when the nominal exchange rate changes, there is a direct and indirect effect

  • depreciating US dollar shifts curve up

  • appreciating US dollar shifts curve down

direct effect

• when the US dollar depreciates, foreign goods are more expensive for people in the US

  • it now takes more US dollars to pay for imported goods

  • boosts inflation

  • increases price of foreign made goods

indirect effect

• more expensive foreign goods lead to higher prices on domestic goods

  • US business that use imported inputs now have higher marginal costs-raise prices

  • US businesses that compete with imported products face less competitive pressure and can raise prices

  • US business that export their products have foreign buyers who are now willing to pay more, and may also raise prices for US customers

shifts vs movements

• demand pull inflation leads to MOVEMENTS along phillips curve

  • increased output gap= excess demand= rising prices= movement(upward and to the right)

  • decreased output gap= insufficient demand= falling prices=movement (downwards and to the left)

• cost-oush inflation leads to a SHIFT in the curve

  • rising input costs, decreasing productivity growth, decpreciating US dollar= rising production costs= rising prices at each output gap= shifts up

  • lower input costs, rising productivity growth, appreciating US dollar= falling production costs= falling prices at each output gap- shifts down